Climate Progress Dashboard – navigating risks and opportunities

Climate change is becoming a defining theme of the global economy.

The Climate Progress Dashboard monitors change indicators across the four categories that have the most influence on limiting global temperature rises: political change, business and finance, technology solutions and entrenched industry (i.e. fossil fuel use).

How rising carbon prices could cut company profits

A new model developed by Schroders provides investors with a more accurate measure of how carbon costs will affect companies.

The investment industry has put huge effort into calling for action on climate change, spawning a wide variety of climate-labelled funds. However, little has been done to understand the investment risks climate change poses or to develop tools to manage them.

Carbon footprints1 are the default measure of climate risk for many investment managers, and the basis for a stream of low carbon investment products. But as a measure of financial risk, carbon footprints bear little relation to potential impacts on profit.

However, Schroders' analysis shows that up to 20% of listed companies’ cashflows are at risk if policies strengthen in line with political commitments. The issue demands a lot more attention than it has received so far from the investment industry.

Be prepared

In July we introduced the Climate Progress Dashboard2, tracking the extent to which key drivers of decarbonisation can mitigate rising temperatures. It shows that containing physical threats to acceptable levels will require far bigger changes than those we have seen implemented so far. Whether that challenge will be met remains unclear but investors should be prepared.

One of the most important climate tools for policymakers remains putting a price on carbon. Close to 30% of the world’s emissions will be covered by carbon-trading schemes by the end of this year.

We developed our Carbon Value at Risk (Carbon VaR) analysis to help our fund managers and analysts better understand how carbon pricing could affect cost structures and profits. It estimates the impact on companies’ earnings of raising carbon prices to $100 a tonne, based on their current exposures, business models and cost structures.

Damage limitation

If we are to hit the internationally agreed target of limiting global warming to 2°C, carbon prices will have to soar from under$5 to well over $100 a tonne by the middle of the century. The effects on companies will be complex. They will face new costs in proportion to the total emissions generated by their operations and power usage. Suppliers will face similar cost increases, which will translate into higher input costs, and selling prices are likely to rise across industries to offset cost increases. This will mean that demand will fall to reflect price elasticity in each market.

The net result of these changes will generally prove negative, but some companies already prepared for a low carbon economy could see profits boosted.

A measured approach

Our Carbon VAR analysis applies a grounded understanding of economics and investment logic, relying on information beyond company reports. While scope one and two emissions3 are relatively straightforward, other factors require more work to understand.

We estimate suppliers’ emissions using input-output tables4. These measure each industry’s reliance on inputs from other industries. In most sectors, supply chain emissions are larger than scope one and two emissions, but are not included in carbon footprints. Failure to include them can significantly distort conclusions5

We calculate the price rises needed in each market to keep profitability the same after carbon prices rise6 and we use academic estimates of price elasticity in representative industries to estimate falls in demand as prices rise to offset industry costs.

The results provide a consistent measure of the risks companies face from rising carbon prices. How the company manages that risk, or how valuation reflects it, are separate considerations.

 

The likely effect of raising carbon prices on the earnings of listed global companies

 

Outdated conventions

Importantly, the conclusions are very different from those implied by the measures most of our industry relies on7. The chart (above) plots conventional carbon footprints from a leading research firm against our estimates of Carbon VaR8, showing that the two bear little relation to each other.

Take the chemicals sector: we looked at two leading companies with superficially similar business models – Linde and Air Products. By adopting our approach to measuring carbon intensity, we found an underlying difference of as much as 60% in the earnings risks they face.

Global concerns

The chemicals sector is not alone. Applying our Carbon VaR framework to a global universe of listed companies, we found the effects are material and stretch far beyond the most obvious sectors. It shows that almost half of listed companies could face a rise/fall of more than 20% in cash earnings if carbon prices rose to $100 a tonne.

Climate change presents huge threats and opportunities. Investors cannot afford to assume that simplistic carbon footprint measures will adequately capture the complexity of climate change risk, or that climate-branded products will provide insurance against climate disruptions.

Analysis must go further and we are committed to strengthening the analysis and tools, including Carbon VaR, to help investors navigate the path ahead.

 


1Carbon footprints typically divide the emissions generated from companies’ operations and the power they consume by their revenues or market cap.

2Further details available here.

3The Green House Gas Protocol definition – scope 1 emissions: direct emissions from owned or controlled sources, scope 2emissions: indirect emissions from the generation of purchased energy.

4We use data from the Bureau of Economic Analysis to build a similar approach to the Carnegie Mellon Green Institute (http://www.eiolca.net/), which tracks the flow of resources between economic sectors.

5Apple and Samsung are a good illustration of this. Both sell similar consumer electronics, yet Samsung’s carbon footprint is significantly higher than Apple’s, primarily because Apple outsources most of the manufacturing, whereas Samsung makes more of its own products. In reality, of course, the emissions created by producing and selling both sets of products are much closer than simple carbon footprints imply.

6Long run industry profitability is a function of fundamentals such as its structure, pricing power and barriers to entry rather than cost structures. We assume those characteristics are unchanged.

7Research firms can reach very different conclusions when estimating the carbon intensities of companies which do not report emissions. CDP, MSCI and Bloomberg estimates for the same universe of large global companies differ by 40tonnes/$m of sales on average, equal to around one quarter of the average company’s footprint.

8The carbon footprints and Carbon VaR values are based on the same scope one and two emissions data.

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